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  • QA 200
    Question:
    Can options help to minimise the consequences of possible defaults?
    Background:
    In your QA 199 you refer to a double risk when a shipper defaults. First, the importer does not get the physical coffee and so cannot meet his obligations towards his own buyer. Second, if he had hedged the purchase he finds himself short on the futures market something that could also cause problems. Can options provide any solutions here?
    Asked by:
    Broker - EU
    Answer:

    Yes, to a certain extent…

    As QA 199 pointed out, default presents enormous problems since the aggrieved party now cannot meet his own delivery obligations. In some instances it may be possible to get the final buyer to accept a substitute coffee but not always and, most likely, nearly always at a cost. This we say because we believe most deliberate defaults occur in rising markets. Of course there are other, invisible costs such as loss of credibility if not a client…

    In today's volatile markets price risk has to be hedged, not only for self-protection but also because of insistence by bankers that risk must be minimised. But, roasters and importers have different pre-occupations…

    Roasters: A roaster does not necessarily need to hedge against price falls by selling futures. If he wishes to protect the price of his physical coffee until it is processed he can simply buy put options: the right to sell futures at a specific price. These will benefit from any price falls until such time as the physical goods are taken into stock, sometimes even later. Of course the option cost adds to the purchase price of the physical coffee but, provides a form of insurance… *

    Importers: If an importer buys from a new supplier and decides he will remain long (the coffee is unsold) until he receives a shipping advice or, in extreme cases, the actual shipping documents, then he can also hedge much of the price risk by buying put options**. We refer to the shipping advice etc because we would suggest that when a buyer feels the need to look for protection against possible default, he would only sell on once he has clear confirmation that the goods have been shipped. And if he is worried about possible default he would probably also hesitate to hedge by selling futures short…

    However, if an importer did decide to hedge by selling futures short then, as you rightly mention, if the shipper defaults the importer ends up with those futures as a net short position. If the default is indeed due to rising prices then such a short position may turn out to be quite expensive…

    If so then buying call options (the right to buy futures at a specific price) at the same time as the futures hedge is entered into will protect against this. Of course this will cost money as the premium has to be paid but, at least the importer will know that he cannot be caught entirely short on the futures if the shipper were to default.

    To note though that call options only provide the right to purchase futures contracts. Whereas one can take delivery of physicals against a futures contract it is not possible to specify from which origin the coffee should come. Therefore, in this scenario the call option only serves to protect against possible loss on the futures short hedge - it does not help with the replacement of the contracted physical coffee, nor does it cover the importer against any differential loss. (See topic 09.01.03 for more on differentials).

    Nevertheless, using options at least makes it possible for importers and others to consider trading with new or relatively unknown counterparts in producing countries. This in turn brings up the point that adequate industry structures, regulations and discipline at origin are also an essential part of the international trade in green coffee. The better an industry is organised, the easier it will be for new entrants to be taken seriously. This because of the assumption that at least they have passed some form of admission control, something that ultimately reflects in the prices buyers pay.

    Chapters 8 and 9 of the Guide discuss Futures, Hedging and Options in considerable detail.

    *   It is rather unusual for roasters to buy direct from relatively unknown parties in origin countries, hence we do not discuss 'default' in this paragraph. But importers do as part of the bridging function they provide for both origin and roasters.

    ** In theory options can be written to cover 100% of the price risk but, obviously, at a higher cost. We would also mention that using options may work out more expensive than using futures but, this is the premium one pays for protection against potential defaults…

    Posted 19 September 2008

    Related chapter(s):
    Related Q & A:
    Q&A 182, 184, 199